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National Oilwell Varco (NOV)

By Adam D. Schwab, CFA, CPA

Investment Thesis

Given the tremendous sell-off in energy the past six months,

we wanted to highlight our investment process and valuation

for one of the few energy names we own. Historically, we have

only found a few energy companies that satisfy our long-term

principles and margin of safety discipline. National Oilwell

Varco easily stands out as a high quality energy company, with

a proven track record of producing shareholder value through

responsible capital allocation. While we like NOV’s business,

we are waiting for a bigger discount to fair value to add to our

position, given the pain that will likely hit the energy industry

over the next few years. Oil has had a great run that last nine

years and we are patient given the likelihood of a significant

cyclical downturn.

National Oilwell Varco is a leading provider of equipment and components used in oil and gas drilling, production, oilfield

services, and supply chain management. National Oilwell was incorporated in 1987, and built its operations primarily

through acquisitions, leading up to the 2005 acquisition of Varco, creating the present day National Oilwell Varco. NOV

operates in six continents, has 61,000 employees, and receives 59% of its revenue from outside North America. The

company has completed over 200 acquisitions the past 15 years, and has leveraged its ability to become market leader in

providing rig and drilling equipment to the energy industry.

The share price of NOV has been dragged down as oil prices have declined more than 50%. The market is overly concerned

with rig order demand over the next 12-18 months, and we see an opportunity in a world-class business. As the complexity

of drilling increases, it further solidifies NOV’s market leading position, creating a barrier to entry as the foremost provider

of rig equipment.

Most importantly, our favorable view on NOV’s business does NOT mean we are overall bullish on the energy sector. Many

energy companies have little margin of safety and we are avoiding those companies. There will be more damage for the

energy industry, which is why we are patiently waiting. Given the volatile and irrational nature of the energy markets, we

are waiting for NOV to be undeservedly punished before adding significantly to our position. NOV, along will all of our

equity investments, requires a 3-5 year holding period.

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Advantages

90% of the world’s rigs use NOV equipment

Over 80% market share of offshore “floater” rig packages

Continued long-term industry investment into new rigs and overhauls of older rigs

Fortress balance sheet that provides protection from industry slow-downs and trough cycles

#1 or #2 market share position in almost all products

Risks

Cyclical industry – net income fell 23% in 2009, the last major oil price collapse

Highly acquisitive company – need to trust the capital allocation decisions of management

Oil price volatility creates extremes in sentiment and swings in rig orders

Highly levered to off-shore rig demand

Segments and Operations

Rig Systems – 8.5B Sales, 44% of Revenue, 41% of EBIT

The Rig Systems division provides and constructs drilling equipment for both onshore and offshore operations. This

division includes manufacture of land rigs, equipment packages, and other drilling components that assist in the drilling

process. Offshore rigs are the biggest component of this segment and have seen excellent growth the past few years.

Capital spending by major oil companies and drillers are primary drivers of revenue and profits for this division. As oil and

gas become harder and more expensive to find, NOV provides the technological innovation to enable profitable extraction

in unconventional fields and ultra-deepwater locations. Rig System’s growth should moderate as new orders slow over

the next two years. Major customers include Transocean, Noble, and Helmerich & Payne.

Rig Aftermarket – 2.7B Sales, 14% of Revenue, 21% of EBIT

The Rig Aftermarket division provides technical support, products, and components to maintain and service drilling rigs.

Aftermarket service and support are provided to oil and gas drillers, with repair facilities located around major drilling

areas. Drilling activity and maintenance demand drives the performance of this division. As more wells are drilled and

completed, the greater the need for replacement parts and consumable products. Ongoing activity of energy companies

drive the use of repair services and spare parts. This segment is more immune to industry slowdowns given the recurring

nature of replacement parts.

Wellbore Technologies – 5.1B Sales, 26.7% of Revenue, 23% of EBIT

Wellbore Technologies provides equipment used in drilling operations. This equipment includes waste management

products, drilling fluids, drill pipe, tubular inspection, downhole tools, and drill bits. This segment is primarily influenced

by drilling/oilfield services companies, well counts, and land activity. These tools and services allow for the successful

drilling and completion of wells.

Completion & Production Solutions – 4.3B Sales, 22.5% of Revenue, 14% of EBIT

Completion & Production Solutions composes hydraulic fracturing stimulation, including pressure pumping, hydration

units, flowline, coiled tubing, and wellheads. Oilfield service companies are the primary operators of hydraulic fracturing

technologies. Half of the revenues are international. Major drivers include workover rig activity and pressure pumping

demand.

Management

Clay Williams, 51, has been CEO since 2014. Prior to the CEO position, he was CFO from 2005 to 2012 and COO from 2012

to 2014. Jeremy Thigpen has been the CFO since 2012. He was previously the President of the downhole tools group and

the downhole and pumping segment. He joined the company in 1991 and has held numerous positions with the company.

Clay William leads a relatively new team at the executive level, although most have been with NOV for decades. The prior

CEO, Pete Miller, did an astounding job navigating NOV through many acquisitions and swings in the energy industry. The

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current team has had excellent training under Miller (2012 Morningstar CEO of the year), but it is still unknown if they can

create and maintain the same level of success Miller produced. The NOV culture and company experience should provide

a stable foundation for wise capital allocation and successful growth. Given NOV’s leading position and relatively big

position in the market, we do not forecast any game-changing acquisitions. We look for management to pursue smaller,

bolt-on acquisitions and optimize its competitive position. Management is committed to returning cash to shareholders,

with a 3.0% dividend yield and an open buyback equal to 10% of the shares outstanding.

Valuation Summary

We believe NOV’s underlying earnings power is approximately $5.35 per share. This earnings number includes our

expectation of a slowdown in new rig orders and deferred equipment demand. Since this industry is cyclical, it is important

to note our earnings power value is not our expectation for any given year. Likely, 2015 will likely bring results below our

target. Longer-term, however, we expect NOV’s assets to generate earnings above the $5 mark. The price (not the value)

of NOV will fluctuate with oil price volatility. These price movements do not change our assessment of value; they simply

provide entry points for buying. Part of the revenue drop from historical years is the result of the spin-off of

DistributionNOW, but we have also incorporated a slowdown in new orders. Long-term operating margins are estimated

at 17% and have been fairly stable the last eight years. We assume no major acquisitions and estimate organic growth in

the 3-4% range. Our growth estimate may be overly conservative, given the rapid development of new energy plays. We

look to take advantage of price weakness if the price approaches $50.

Fair value estimate per share:

Underlying Earnings Power

5 year Annual Growth Rate

Cost of Capital Terminal (long-term) Growth Rate

Value per share

Best Case 5.75 4% 8.5% 2% $97

Base Case 5.35 3.5% 8.5% 2% $83

Worst Case 4.08 1% 8.5% 0% $50

Conclusion

National Oilwell Varco stands out as the dominant provider of energy equipment. NOV has outstanding earnings growth

potential with strong future free cash flow. NOV returns cash through dividends (3.0% yield) and initiated a share buyback.

Many energy companies run themselves into the ground by chasing fast growth, becoming highly levered at the peak of

the cycle, and then getting wiped out as the boom turns to bust, destroying shareholder value in the process. NOV has a

proven track record of consistently creating shareholder value, while maintaining a conservative balance sheet. These

attributes allow the company to leverage industry downturns by gaining share and consolidating weaker competitors. As

investors and the general public continue to debate where the price of oil is going, we are focused on the long-term

positioning of NOV and ability to generate tremendous free cash flow and earnings growth over the next decade. We will

take advantage of excessive stock price declines to increase our position in NOV. We are carefully watching the changes

in the energy industry as oil approaches $50. While the market is overly fixated about order demand over the next 12-18

months, we can use price volatility to our advantage and increase our position.

Recommendation: HOLD, Add to position at our consider buy price

Action Price Methodology

Consider Sell $91 10% premium to our base-case value

Base-case Value $83

Consider Buy $50 40% discount to our base-case value

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About Elgethun Capital Management, Inc.

Elgethun Capital Management is a fee-based, fiduciary Registered Investment Advisory (RIA) firm established in 2003. We are registered with the

Securities & Exchange Commission (SEC) and subject to their audit reviews. We are independently owned and operated. As of September 30, 2014,

we had approximately $230 million dollars under management/advisement. Our clients are high-net-worth individual investors and institutional

investors. Our investments include: individual stocks, bonds, and stock and bond mutual funds.

Disclaimer

The discussion of portfolio investments represents the views of the investment manager. These views are current as of the date of this commentary

but are subject to change without notice. As of the date of this publication, Elgethun Capital Management has a position in the security mentioned

herein and may purchase or sell shares at any time without notice. All information provided is for informational purposes only and should not be

considered investment advice or a recommendation to purchase or sell any specific security. Security examples featured are samples for presentation

purposes and are intended to illustrate our investment philosophy and its application. While the information presented herein is believed to be reliable,

no representations or warranty is made concerning the accuracy of any data presented. Portfolio composition will change due to ongoing

management of the portfolios. References to individual securities are for informational purposes only and should not be construed as

recommendations by Elgethun Capital Management or its members.